Question

#13. You own a house worth $250,000 and intend to insure it fully against fire for the next year. Suppose the probability of its burning to the ground during the year is .0001 and that an insurance policy covering the full value costs $500.

Consider the insurance policy as a security.

a. What is the expected holding-period return?

b. What is the standard deviation of it HPR

c. Would you consider this policy to be a very risky asset? Why or why not?

This is not in my notes and I am unsure how to work the solution

Answer 1

The fact of the question is that a house worth $250,000 is owned. There is no mention about the intention to sell the house after any number of years. Also there is no mention of any income from the house through any means. Also there is no mention of usual period or life of house or any depreciation. Without these info, we have assume that the house is used by the owner to stay and no income is derived from the house and house is at same value at end of 1 year.

a. Holding period return =

The property tax or the Mill Levy is one mill per $ 1,000 of property value. Hence for this house mill levy = 250,000/1000 = $250.

As per our assumption, income = 0; end of period value = $250,000, initial value = $ 250,000

HPR = [0+(250,000-250,000)]/250,000 = 0. There is no return from this house.

b. Since the HPR is 0 the standard deviation of HPR is also 0.

c. There is almost negligible chance of house getting damaged fully (0.01%) and that is covered adequately by insurance. This policy is not a risky asset, infact it is the most safe asset.